Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Year-end is fast approaching, and based on web traffic it seems like the question of converting traditional IRA savings to Roth savings looms large. Congress has added to the buzz by allowing the conversion of certain pre-tax 401(k) money into Roth money (though few plans will offer this option in 2010).

Before you jump on the conversion bandwagon, I want to raise a critical question: What if tax rates don’t go up?

Conversion to Roth makes sense generally if you believe future tax rates in retirement will be higher than today’s. With looming fiscal challenges facing the U.S. government (as I’ve blogged about previously), the dominant assumption is that federal income tax rates will most certainly rise. But here’s another scenario. What if taxes go up—but tax rates fall?

Consider tax reform ideas from the President’s commission on deficit reduction. Those proposals envision a lower set of tax rates than today, although they raise tax dollars by phasing out various preferences. Other tax reformers have suggested raising revenues in other ways, such as a VAT tax, to close the fiscal gap, which leaves rates unaffected. Under these scenarios, taxes to the government might rise—but the marginal tax rate on retirement dollars might still be lower in retirement.

I’m not trying to dissuade investors worried about tax rate increases from converting today. But Roth advocates need to be cognizant that there is some risk, almost impossible to assess, that the conventional wisdom on taxes—higher marginal tax rates will be needed to address federal deficits—may be wrong. Your taxes can go up even while tax rates are lower. Or taxes can be increased in other ways. And it is the marginal income tax rate you pay that will dictate whether pre-tax or Roth savings make sense in the long run.

Our advice, in the face of this uncertainty, is tax diversification: maintain pools of pre-tax savings to hedge against falling rates, and Roth savings to hedge against rising rates.

A final thought: Roth conversions are complicated, so be sure to consult our content on vanguard.com, as well as your tax or financial adviser, to help think through the issue.

Note: If you take withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax on withdrawals. The amount you convert to a Roth IRA is not subject to the 10% penalty.

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Steve Utkus

Steve Utkus oversees the Vanguard Center for Retirement Research, which studies many aspects of retirement in America—from how individuals start saving and investing in the early part of their careers, to how they prepare for actual retirement, to how they spend down their savings once they’re retired. Steve is particularly interested in behavioral finance—the study of how rational decision-making is influenced by human psychology. His current research interests also include the ways employers design retirement programs, and new developments in retirement in other countries. Steve holds a B.S. from the Massachusetts Institute of Technology and an M.B.A. from the University of Pennsylvania's Wharton School. He began working at Vanguard in 1987 and has served as director of the Center for Retirement Research since 2001. Steve is also a visiting scholar at the Wharton School.

Comments

Anonymous | December 30, 2010 10:36 pm

Dec 27th person, I appreciate your comments.

Let’s say you have an existing Roth IRA, traditional IRA, and a rollover IRA. All of your contributions to your traditional IRA have been non-deductible and you have kept track of this on your 8606 forms with the IRS to determine your basis.

However, let’s also say that all of your contributions to your rollover IRA are from deductible contributions (i.e., rollover IRA was from an old 401K).

If you take both your traditional and rollover IRAs and convert those to a Roth IRA, then how would you calculate your pro rata basis to determine how much tax you have to pay on the conversion? Do you include your existing amounts in your previously set up Roth IRA when determining the total value of “all” IRA assets? No one has been able to answer this question for me.

If Dec 27th person can answer (or anyone else), then that would be great.

Anonymous | December 28, 2010 7:58 pm

Another consideration is if you are 70 1/2 and taking a RMD your income is increased by this distribution and may increase your overall taxes.
By converting to a ROTH your RMD is lowered thus reducing your Income/Taxes.

Anonymous | December 28, 2010 5:58 pm

The whole “conversion question” is so complicated and (in my mind) fraught with peril that I have decided to maintain the status quo. My philosophy is simple – if you don’t understand something, stay out of it. And that is the reason I am avoiding the conversion game. As the article suggests, I am instead focusing on tax diversification. Although my 401(k) is pre-tax, I am hedging that by fully funding my Roth IRA each year.

Anonymous | December 28, 2010 2:11 pm

I found the article very informative. It offered some situations not commonly discussed. It is difficult to predict what will happen with the tax policy. As all these article note you need to consult your tax advisor before making a decision. I think that everyone is in a differnt situation and you need to look at your tax return, yearly living expenses, etc. and make your decisions on that. In the long run getting money from an account and oweing no taxes is nice. But if you would owe no taxes during with withdrawal at a later date, why pay them earlier? How about a falt tax??????

Anonymous | December 27, 2010 9:32 pm

I do not understand the December 19 comment. My understanding is that if your traditional IRAs come entirely from deductible contributions, then whatever dollars you convert from traditional to Roth are taxable. On the other hand, if the value of all your traditional IRAs combined is, say, a total of 81% from deductible contr’ns and 19% from nondeductible contr’ns, then 81% of the dollars you convert would be taxable, regardless of which particular IRA(s) the dollars come from. Whether you already have an existing Roth IRA or whether you are creating your very first Roth IRA has nothing to do with how many of the traditional IRA dollars being converted will be taxable. However, please double check with a professional tax advisor, which I am not.

Anonymous | December 21, 2010 12:54 pm

Anonymous | December 20, 2010 4:59 pm

Man, I’m really getting sick and tired of all this gamemenship. Financial pundits are screaming, “convert, convert”! Then someone figures out that by converting you may put yourself in a higher tax bracket. Then someone else figures out that by converting you are slitting your wrists when it comes to Medicare premiums. Now what happens if we go to means testing for Social Security?
My Social Secirity helps pay for our Long Term Care Insurance premiums and guess what? The premiums are set to go up 40% or more
You really want to know what I think (probably not). This game is rigged!!!

Jim U. | May 14, 2016 8:33 pm

Mr. Dec 20th seems to really be paranoid about higher tax brackets and slitting his own wrists if he converts a traditional IRA to a ROTH. Well I got news for you friend; if you don’t become pro-active concerning converting some/alot of your IRA assets BEFORE the taxman comes with his RMD mandates, THEY (IRS and Social Security) will start slitting your wrists for you while your arms are strapped to a chair. By that time it will be too late to do something about your taxable income and you will start to really bleed from the additional taxes and additional Medicare Part-B charges. You will be stuck in that chair, paying and paying and paying. The trick is to keep your RMD driven taxable income (during retirement) low enough to keep you out of the higher brackets, and keep your AGI low enough to avoid the Medicare surcharges. Thanks to the persistence of Senator WiIliam Roth, one way out of this blood letting is the ROTH conversion BEFORE the RMD tax man comes knocking at your door. The bleeding becomes very profuse when you or your spouse joins the “single” tax table group. All this bleeding was increased by features of the UN-AFFORDABLE CARE ACT in the form of low or no deduction of medical expenses and increased Medicare surcharges (really a tax since you won’t be able to deduct them). I’m so glad I started my conversions over 15 years ago. In 2017 my RMD will be about $5k, instead of almost $32k. I’m glad I saw the future back then.

David R. | July 3, 2016 7:52 am

I agree with you. I will be 70 1/2 in 2017 and have been converting to my Roth for about 10 years now. I figure all wages, pension, social security etc, figure married standard deduction and convert as much as I can without getting out of the 15% tax bracket. I figure I’ll never do better than 15% so why not go ahead and pay it. It has lowered my future RMD’s but like you said, the bigger issue is what happens when one of us dies and the other person is single. The same RMD will be coming out, but as a single person the taxes will be much higher. It’s for sure a rigged system like someone said, but it will pay off if we plan now.

Anonymous | December 19, 2010 11:31 pm

Ricardo M. | January 7, 2016 3:54 pm

After one has withdrawn some of the RMD ,these are free dollars. Use this to convert 20 to 40 K$ per year (or more) to an existing ROTH for 10 years or more (now you are 80 1/2 and closer to death and passing tax free dollars to heirs.)
Assuming the tax rate is static, one pays the total tax now or in the future. If you are good at investments and your Traditional increases each year, then you will be paying more taxes each year which helps the government. If you are a good investor, then ALL of your gains in the ROTH are tax free.
This may be the reason the DC politicians are considering eliminating ROTH conversions.

Anonymous | December 17, 2010 5:55 pm

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.